Downtown Philadelphia in state of flux as mergers loom

Like several other major cities, Philadelphia is watching its Central Business District shrink as companies head for newer office space in the suburbs. Making matters worse, the city is preparing for the big-time job losses that will result when three major mergers are consummated.

However, with the metro area experiencing good economic times and the suburbs recording single-digit vacancy rates, developers are ready to build new space in the suburbs. Those involved in real estate are busy figuring out how to position downtown Philadelphia within the metro area's real estate market.

Earlier this summer, National Real Estate Investor gathered 12 real estate experts to find out what's going on in Philadelphia; here's what they said.

NREI: Ron Cariola with Equis can you give us a quick synopsis of the Philadelphia-area office market?

Cariola: The office market trends are for the most part favorable, a lot of activity, certainly out in the suburbs more than in the Central Business District. Right now our current stats show the current CBD vacancy rate to be about 14.4%, 19.7% on the east side of Market Street, 12.2% on the west side. In the Philadelphia suburbs, the PA side the vacancy rate is about 5.2%, which does not include the new product that's under construction. Rental rates in the suburbs are up; the average rental rate for the PA suburbs is about $24.50 per sq. ft. for class A office product. In the New Jersey suburbs, for the first time in about eight years, vacancy is in the single digits, about 7.5%, and rental rates there for class A office product are about $20 a sq. ft.

When you look at the benchmark of where Philadelphia's been historically, one of the trends that I find interesting is to look at Philadelphia relative to some of the other large cities in other parts of the country. When you compare Philadelphia, it's going to be no surprise to anybody in this room, that we have one of the tighter suburban markets in office. All over the country, vacancies are about 5%. Part of that is fueled by the suburbs' internal growth and some of the economic factors, both local and national, but a big part of that is also fueled at the expense of the CBD. Underlying the foundation of the CBD are a couple of major corporate consolidations that we all know about. First Union will be putting about 200,000 sq. ft. back on the market; BellAtlantic, with the merger with Nynex, it's just a matter of time before they put a large chunk of space back on the market. CSX, Norfolk Southern and Conrail, and then you have Raytheon consolidating. We really have not felt the impact of all of those.

In addition to that, there's something else that a lot of other CBDs don't have, and that's the City Wage Tax differential relative to the suburbs that just on a thumbnail sketch, you take the take the average employee making about $42,000 a year in Philadelphia and you multiply that by 3.5%, figuring in that the suburbs have a 1% wage tax already, add in another $100 a month for transportation to the city and divide that by about 225 sq. ft. per employee, and you're looking at a $12 a sq. ft. spread in the CBD versus the suburbs.

NREI: From an economic development standpoint, what is being done to brace the area for the pending exoduses of jobs associated with the mergers mentioned earlier?

Greg Byrnes: Philadelphia has been able to overcome these previous exoduses, and I think there's enough activity going on right now that we'll be able to fill it up in time. One of the things we're more concerned with right now with the prospects that we're dealing is the number who are really taking a look at the suburbs. We're trying to get more to take an interest in the Center City. I was in New York two weeks ago at the bio-international conference that Gov. Tom Ridge also attended - he was the bio-tech mayor of the year - and we actually walked away with two prospects that are considering the Navy Yard for bio-tech placements. So, we feel we can sell Philadelphia in the right market.

I think what's happening in Philadelphia right now is you've got the feeling that Philadelphia is Fun City, USA. There's a lot of entertainment complexes being talked about, and tourism, this is really where Philadelphia's strength lies.

Walter D'Alessio: Just to finish Greg's sentence, the Convention Center is now planning its major expansion we all talked about for some period of time. Because the marketplace has been so receptive, the Convention Center, which has been such a great success in its current size, will increase almost 100%, probably 75-85% in terms of total exhibit space, and that's been fueling the hotel-building boom and conversions in Center City, which continues to do well in spite of concern about overbuilding. Try to get a hotel room in-town other than perhaps some weekend in August, and you have a tough time; so we still have quite a bit of activity in that area. Decisions by national and perhaps international players on the retail and particularly the entertainment-retailing side, making their own judgment about the city and moving in actually before almost anybody knew they were on the scene, the Hard Rock Cafe, much the same way. It's now kind of a good indication that the role of the city keeps changing; it will be less important as an office center and more important as a meeting, entertainment, visitors center. If the plans that have been discussed for so long and the players we've have heard from them take their next step. The entertainment complex proposal, I think that will move well. Look at the entertainment that has grown up privately along, without any public assistance, along the river front today, it's done very well. So the nightclub scene, new museums that are there like the Seaport Museum and others are doing very well. So the city's changing its role in the region again, and there isn't any question that Wage Tax and cost of operation in certain sectors are going to make it noncompetitive. It's still, though, going to be an important location for certain kinds of business and always will have a fairly important role for certain kinds of law firms and financial services companies and will become less important for services that are provided in a broader region. We're in a wonderfully changing business. The economy creates opportunities and some dead-spots in real estate as well. Overall, the economy is just terrific, and this marketplace is great compared to even the hotter areas of the Southeast. It's a nice, steady, continuing market, and for those who understand it and follow it, well, it's been very rewarding.

NREI: Bill, do your clients at Cushman & Wakefield want to be in the Center City area, or does the Wage Tax scare them away?

Bill Luff: I think that the accurate answer is that it is really dependent on every situation on different objectives and goals that they have. We don't see an increased trend, but what we see is the steady kind of seepage intensify from the CBD to the suburban market in the past seven years. I'm not talking about the exodus of jobs due to consolidations and mergers but rather the company that could locate in the city or in the suburbs. The cost driving a lot of those people is usually smaller companies, and that's why it tends to be more of a seepage than an exodus of tenants. We do not have an abundance of our Center City tenants come to us and and say, "Analyze the cost differential." Just to explain, we have a range of $7 and $17 a sq. ft. (cost differential) versus the $12 (estimated by Cariola), which certainly is within the range. I don't think that's a driving factor. There are usually a combination of reasons for people to to look elsewhere in the marketplace: Labor, ease of doing business against proximity to a supplier. We do not get tenants who essentially come to us an say, "Let's just analyze the differences" with any great repetition.

Vince Rogusky: One of the underlying issues that we face is the fact that employment is at such a high basis. Companies first and foremost are concerned about will they find the employees, and not to lose employees based on a real estate decision. If you're a suburban-based company that's made the decision to move into the city, even though you could save a certain percentage on your rent, the question is not how many employees are going to move to the city, but will the ultimate loss be far greater than what you're going to gain from a standing of real estate. Vice versa, for an urban company that's located in the CBD looking to move to the suburbs, you have a similar issue.

NREI: Let's change the topic to development and redevelopment. What's happening on the development side and with Thomas Development Partner's Commerce Square?

Randall Scott: Commerce Square, of course is built-out. We have two office towers there; we have a parcel of land that is adjacent to those properties that was intended to be a third office tower that of course, we're not at the feasible rents, so it's now an alternative-use analysis. In terms of our existing tenant base at Commerce Square, of course we are the home of Conrail at Two Commerce, and we are as anxious as anyone else to learn what the ultimate outcome of that user is going to be. They will have a diminished presence in the city. The issues are really how much less and when will they deliver space to the market.

NREI: Is there any spec office development in Philadelphia?

Scott: No.

Clive Mendelow: SmithKline Beecham is the only construction. It's the only crane that you see on our horizon.

NREI: What about in the suburbs. Is there spec development there? What are some of the bigger projects?

Kevin Flynn: We are in the process of eventually planning for final approval to build 325,000 sq. ft. in a nine-story building at the intersection of the Pennsylvania Turnpike and I-476 (the Blue Route) - the old George Washington Motor Lodge - and that's a pretty aggressive project, especially for us. I don't like spec buildings per se, but I think the market's right. If you're there with the right product at the right number, there is a demand. We're one of the few marketplaces I've seen where today you can probably do a build-to-suit for less money than you can to take an existing office. That's a one-story, two-story type office building of the garden variety. There's a need not only for buildings, but for land, too, because there are no more industrial parks which became commercial, or there are very few of them in the Delaware Valley, where in the early '80s, you had all kinds of parks, all kinds of land already for development.

Richard Jones: There are about 10 to 15 projects planned in the suburbs; Kevin mentioned some. There are a total of about over a million sq. ft. talked about, being planned, ready to go or are at some stage.

Rogusky: I think the large expansions in the suburbs largely surround the pharmaceutical industry.

Jones: There is something going on in Center City. Some of us attended a program yesterday (June 30). They held two seminars on how to approach office market in downtown Philadelphia. I brought these two books with me ... that statistically show how important the office market is too Philadelphia. One number struck me: 40% of all the jobs in Philadelphia County are in Center City alone, which would be Market Street, JFK, perhaps Chestnut Street. I mean that's the market, and how important it is for Philadelphia to do something with this office space because you can have sublet total of about 1.8 million sq. ft. when all this, in terms of [the mergers]. That's bigger than you had back in the early '90s.

One of the things that Vince brought up is the idea of the employment base. Philadelphia has a large employment base that can turn out to be one of its biggest assets. The central part of the state's about 3.3% unemployment; the state of Delaware's 3.2%; the city has a higher [rate]. The city has lagged the region with that, but it's an asset that can be turned into a very positive when leasing space up. People will not come into markets with a big space requirement, or maybe even a small, without a trained work force or a work force that's going to get the job done.

Walt's right, the entertainment has picked up dramatically, but it lags far behind the total base of the white-collar jobs. So we can't forget that as the entertainment growth continues.

Mendelow: I'd like to pick up on a rather interesting phenomenon. We're going to have without question, all these job losses with all of these consolidations at Core States and Bell Atlantic and Raytheon. However, what we were talking about before, as Dick mentioned, the concept of what it does to property values. Interestingly enough, while you have the job loss, you still have high-credit tenants paying rent for a long time. And the issue then becomes, what happens to those property values? Does the job loss, because there's a negative impact on the property values - steady income, credit tenants behind the rents - does that mean that you've got a maintaining and operating hiccup? Or are owners going to do a bit better, perhaps, because they're not managing or operating all that space? At the same time what's the effect? I raise this as a question; I'm not suggesting that I have the answer.

D'Alessio: I don't have an answer either, but it is interesting that you pick up a good point that there's been has been significant amount of sale activity of Center City office buildings, particularly higher quality buildings over the past several months, most recent of which people are fully aware of.

Andy Oliver: We actually just sold three office buildings here in Philadelphia in the past year, and each time we've marketed a building, we've gotten more and more interest particularly from people outside Philadelphia, national interest. One main reason we see is low prices and the upside potential that you can't get anywhere else in any large city or city in the USA.

James Paterno: I think one of the threats to value of properties that's going to surface as we get closer to these spaces actually being vacated is the drain on the surrounding properties. The businesses that are there feeding off of the employees and all of a sudden you've got a lower employee base affecting property values and businesses surrounding, which can create opportunity if you are an owner of those properties, just start to buy up to protect your perimeter. And at the same time, it can also create that downward spiral in terms of the urban energy and the urban street-scaping. I think that's an implication that can feed over to the tourism business and just the general momentum that the city has been benefiting from. So that's a danger that I think will be felt as we get closer to vacancies.

Jones: There's an economic impact. I don't disagree that the retail and entertainment industry is getting bigger; you can see that in all the statistics. But they're lower paying jobs, and the Wage Tax implication in the city is not good because their wage base is being deteriorated.

Byrnes: But at the same time, you're starting to see an industrial renaissance with the Navy Yard. In addition to that - it hasn't been announced yet - but the governor and the state are looking at creating Opportunity Zones incentives throughout the state of Pennsylvania. Obviously, Philadelphia will get one, and there you're looking at allowing a major incentive is going to be no local or state taxes for 10 or 12 years. I think that's going to have a tremendous impact in terms of spurring and continuing development at the Navy Yard and hopefully in some other sites that are available in some of the older industrial site in Philadelphia. I think that's going to make up for, as your pointing out, the lower wages in the future.

Cariola: There's nobody that says to me, "Ron, I'm in the suburbs, I want to look downtown." In Philadelphia, our whole identity is derived from the Center City, and the suburbs by the city itself. Despite the retail and hospitality and tourism, the office market is deteriorating.

Mendelow: But what about the reverse base-rent phenomenon? There's some of us in this room who can remember when the rent in Philadelphia was $24.50 and the rent in the suburbs was $8 or $10. And, now the the rent in the suburbs, I think Ron gave a very interesting overview, and you talked about suburban rents about $24.50.

Cariola: Even if it's $10 a sq. ft., you can't get those people to come down. Look at Boston, where it's up to $40 a sq. ft. Their vacancy is 2% in the CBD. Philadelphia is a very similar city to Boston. Why can't we get people to stay downtown?

D'Alessio: The reason that Boston has done so well is the suburban transportation is impossible, and we made it easy through a set of highway policies to disperse. We've exported a lot of the better things. These things keep changing. Today's sense of values are going to be different. We grew up having a suburban house with a big lawn that you mowed on weekends. Lifestyle keeps changing; job interests keep changing; location of where you want to live and the lifestyle you want to live changes, and we'll keep changing with it. This is not a snapshot; this is a movie picture, and we should just keep it in mind. The trends we see today aren't necessarily going to be there tomorrow or the week after that. We've all made a big career our of anticipating some of the trends and trying to be there when they occur, and I think they're coming again.

Gabe Spector: The CBD residential population is already showing increases, and if that continues and jobs follow the residents, then maybe that is a savior for some of the CBD office space. When you analyze each office building, you're really not going to get into all of the theoretical lists that you talk about which firms are there, what's their prospects, and if you look at the population of that building and say, "Hey, that's in an industry where I complete elsewhere." You have to have that at the time you're underwriting that building. Unfortunately, I think a lot of the buyers of these buildings are working for companies where the prime limit is money. It's public money or whatever, and the individuals look at it and say, "I've got to get that money out today." I work for a private company where they look at it and say, "We're going to be here 10 years down the road," and we want today are the companies that are in that building the kinds of companies that are going to be here in 10 years. Law firms? Yes, they're going to remain downtown. Certain types of financial firms? Yes, they're going to be here downtown. You look at other types, and you say, "Are you sure there going to be here?"

Paterno: Here's a radical, maybe a radical, idea that may be one that's a great investment idea for the city. Why not take one of these buildings that are empty or near-empty and have the city buy the building on a spec basis and use that to entice industry to town? Save it for those companies or corporations that are looking out in the suburbs, really giving just a quick nod to Center City. And say, "We'll put you in this space for $2 a foot for the next 20 years," and use that as an incentive. That will help with the absorption; it will help with the vacancy situation. It will also help to generate some industry-sector marketing, which is something that Greg and I were talking about. You've got the pharmaceutical industry, the computer industry. Use a building like this as an incubator, but make the firm commit to a long-term situation in town and take different approaches. The city is not going to lose; it's probably one of the best investments you can make.

Flynn: How about the fellow who owns the building, the private investor who owns the building next to that? The city already competes with private industry so greatly that why do we bother? If you own real estate in Center City, if you physically own it yourself, your look at real estate is going to change drastically, and your opinion of what's going on changes drastically. You look at it differently.

Rogusky: I think if the private owner can receive some subsidy from the state, and it will save developers money on the high-tech incubator situation. I think the fact that, with the residential development and the changes in the local base of entertainment, I think there is some attraction to lure people, especially in that type of industry, to locate in the city. I don't think you'll see the wholesale movement of headquarters, but you can certainly see expansion of the businesses with operations already. But a state-backed program it seems will allow a local developer to compete.

Flynn: It doesn't matter who it is or where you are, if they get into the business you're in, it's time for you to get out. You cannot compete with tax dollars. They're spending your tax dollars to compete with you. First of all, it will never work, never work. For 35 years I've been watching it, and it hasn't worked. In spite of itself, things do happen, but it has never worked as a program. It's not going to work in the future either.

Jones: I think that Kevin's right. A way to do what's been suggested: The city can have investment programs, tax-abatement programs; they can work with the utility companies to give abatements on utilities. What the city doesn't have, or we'd all know about, is a galvanized approach that would give the Center City office district a concerted effort to go after. Redeem what's there and help the organic growth - the companies that are here - and also make sure no one else leaves and then, on the positive side, the proactive side, in marketing to those kind of tenants that should be in Philadelphia or at least be a candidate.

NREI: Let's switch the subject. What has been the effect of consolidation in the real estate industry on Philadelphia. Let's start with Dick (whose firm, Jackson-Cross Co., has just been acquired by Insignia/ESG).

Jones: The pure and quick case study. We were a 122-year-old company, and the company just changed hands in '96 and we had new ownership outside and inside. We did the studies. We were a member of Oncor since 1977. It served us well for many years, but we found out that people like Bill's company (Cushman & Wakefield) and CB, bigger brokerage firms, those that have the New York connection and a true national platform were getting opportunities that we used to get our share and someone else's. We looked at all the national platforms, and they're all pretty much on target, and they're all good strategies and they're all strong. There were redundancies with certain companies like Bill's company and CB. The reason that I think we became Insignia was because of the New York presence they have, the national connections they have, the fact that we were barbelled with Washington on the other side with a very good company in Barnes Morris. We thought it was the time to get a truly national platform because for the foreseeable future - I'm going to say nothing stays forever, maybe some day they will buy themselves back at a very cheap rate - but in the meantime, five to seven to eight, 10 years out, this is where we think we need a national platform.

D'Alessio: My part of the business, the national real estate finance side, started consolidating 10 years ago before the last recession and has been consolidating ever since. We're still Philadelphia based, and our bigger operations are primarily in the South - eight states and 18 offices, and that's not large enough today. What we got was consolidation of some duplicate functions as we acquire companies. It's not large enough because the sources of capital have changed. If you're going to deal with Wall Street sources of funds, what you learn very quickly is you're working for pennies while they're working for dollars and you want to be in their business. So to be be big enough to be your own conduit, your own mortgage REIT and things like that, you have to be a national player. You've got to be bigger, but I worry though about the multiple disciplines required if you start reaching out to other areas of services. We've all watched in so many years, everybody that kind of came through one part of the business or another decided for a while to be a developer because developers were making big money. We've kind of gone through these test periods, and what worries me is you lose sight of the fact that the real estate business still is a very localized kind of business where the rubber hits the road. You can have all the great information about all the offices and everything, but still, knowing the right deal and the right financing source and the right loan-to-value ratios, you still don't know your local market. So getting into some of these other areas and getting too far away from the local nature of the real estate industry worries me some. Just to shift totally, one area where I think we'll see a lot of change in a relative short period time is the REIT industry itself. I think the equity REITs are getting a fair amount of pressure now, some of the larger ones in particular. The really big guys are seeing significant drops in their value. I think some of the smaller ones that have done better are more tightly managed or regionally disciplined, and I think you're going to see a fair number of consolidations and perhaps even some sales out of some of those REITs that have put together portfolios where pretty soon the cash flow, the values of the portfolios will pass each other. I think consolidation in the REIT industry is something that will occur sooner rather than later.

NREI: For the final question. How long can this real estate cycle last?